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Separately Managed Accounts vs. Passive Management Part I of II

By: Investor Solutions

By: Investor Solutions, Inc.

Over the last several years, there has been a significant increase in the popularity of separately managed accounts over mutual funds for high net worth individuals. Some might say that SMAs, with all of their bells and whistles, have a clear cut advantage over the standard actively managed mutual fund and I would even have to agree. However, when comparing separately managed accounts that often provide low costs, better performance, tax loss harvesting, low turnover and complete transparency to a passively managed index strategy, a lot of those advantages seem to disappear.

One of the biggest misconceptions promoted by those that offer separately managed accounts is the low cost associated with these elite money managers. It is true, occasionally clients are able to negotiate the fee with their financial advisors and reduce their total expense below the standard actively managed mutual fund. Normally the more money given to invest, the higher your leveraging power is at bringing the “all in” fee down. The “all in” fee includes the manager’s expense, the trading cost, and the amount remaining goes to the financial advisor who then hands some of that over to his broker dealer for doing business. The “all in” fee on a separately managed account ranges between 2-3% and depends on the amount of money allocated between equity and bond managers. Right off the bat this presents an extreme disadvantage for a separate account manager competing against his most relative benchmark and having to make up 2-3% in performance by the end of each year just to cover his fees. It is like running a 100 yard race starting at the 130 yard mark each and every year.

There is an option for the client who is looking to save a little by going directly to the money manager. This would cut out the fee you pay to the advisor and reduce your overall cost. Unfortunately, I would not recommend this for two reasons. Normally you need a minimum of at least $10 million in investable assets to get in the door. The second reason is that there is not a disciplined monitoring mechanism in place to make sure your manager is living up to expectations (beating his benchmark consistently). Most broker dealers have a team of research analysts that monitor your money managers to make sure they are behaving and performing appropriately. Whether you know it or not, part of the “all in” fee you pay covers the expense of the research team that monitors your separate account managers.

One final expense that might be included in the “all in” fee is for those clients invested in the sexy, and “up and coming” accounts known as MDAs (Multi Disciplined Accounts) or UMAs (Unified Managed Accounts). MDAs are essentially 3-5 separate account managers in one account with one account number. They normally hire an overlay manager at an additional cost to the client who monitors the several managers in the one account to make trades and prevent any overlap. A UMA is one universal account that has the ability to hold a variety of separate account managers, mutual funds, ETFs and other investments. MDAs and UMAs might be nice, but ultimately the client is paying a premium for an aesthetically appealing account he may not necessarily need. Presently with all these different hands in the pot, this leaves little room for discounting or fee reduction.

Alternatively, expenses on a passively managed index strategy are almost nil in comparison. Index funds and or ETFs have internal expenses starting as low as 18 basis points (.18%) and increase slightly based on the style and objective of the fund. The only other additional expense of a passively managed strategy is if you choose to hire a toptiered investment advisor to manage an appropriately diversified portfolio of passive investments, which may be as high as 1%. For investors looking for disciplined investment and oversight whose objective is attaining the highest return per unit of risk this is an absolute bargain.

Fees Matter

(Source: Dimensional Fund Advisors)

As you can see above, the cost of doing business with separately managed accounts compared to a passively managed strategy can be quite high. Starting with a $1 million initial investment and based on a 6.5% annualized return over 30 years, if you pay 2% in fees instead of a 1% you lose $1,238,633 ($4,983,951 – $3,745,318 = $1,238,633). With the same assumptions if you pay 3% in fees instead of 1%, your account total is significantly reduced by an astounding $2,177,157 ($4,983,951 – $2,806,794 = $2,177,157). We all know that there is no such thing as a free lunch, however, when the same $15 sandwich is selling for $5 dollars across the street. I am going to get some exercise and take a walk across the street.

A few of the other bells and whistles we mentioned earlier on separately managed accounts include tax loss harvesting, low turnover and complete transparency. In my next article, I will touch on these topics and explain why passive management for the long term is ultimately superior over active management within separately managed accounts.